Q: Would you tell us about the mission of the fund and how the mandate has evolved?
The portfolio is a core bond fund that has a broad global multi-sector mandate. Its goal is to generate income and price appreciation, and to outperform the broad fixed-income market, though we also manage with an eye towards total return
As far as evolution is concerned, the fund’s objectives and approaches have been in place for the last decade. Prior to that, its investment universe was a bit more constrained; the mandate did not use many global securities or those below investment grade.
I have been lead portfolio manager since 2007 and part of the management team after Alliance bought Sanford Bernstein in 2000.
Q: What is your investment philosophy?
We believe there are long-term systematic mispricings in fixed-income markets due to different issues investors face, such as emotions, market complexity, and conflicting investment agendas. So rather than depending solely on our ability in the short run to time ups and downs in the market, we try to identify such inefficiencies and take advantage of them to drive long-term performance.
Also, spreading the portfolio’s risk budget across many types of opportunities rather than focusing on one particular area like duration betting generates a better return and a better ride for investors. We keep duration betting to only 15%–20% of the overall risk budget because it can be a challenging area to get right every day. A greater part of the return comes from sector and security selection, because research gives us a bigger advantage than does forecasting interest rates.
Q: What is your investment strategy?
Our entire fixed-income platform shares common research and the same research review process to ensure the best ideas get into all our funds.
Our investments process starts with expected return and risk and scenario forecasts generated from over 65 research professionals from our quantitative and fundamental research teams. We believe that our blending of quantitative and fundamental research as complementary inputs is truly unique and differentiates us from other managers.
It continues with a series of research review meetings, which are broken down by the four market segments most relevant for this mandate: global rates and currencies, corporate credit, securitized assets, and emerging markets. These meetings bring together the appropriate portfolio managers, researchers, and traders to vet research forecasts, bring in any additional market information necessary, and try to distill this into key themes for each of these sectors.
The appropriate portfolio managers for individual products take these inputs to combine themes coming out of the individual research with top-down macro views to set the overall risk budget and the broad parameters (e.g., duration and currency positioning, sector and subsector allocations, etc.) Security selection is typically made by sector specialists; for example, individual corporate bonds are selected with the help of our credit team.
Q: How does your research process work and where do you look for opportunities?
Technology investments—many of them proprietary—permeate our research, and since the crisis this has taken on additional importance. We built databases to facilitate access by the research team to both quantitative and fundamental data, and a tremendous amount of resources went into disseminating their output to portfolio managers and traders. The significant upgrade in our technology and trading infrastructure is a key part of our success.
As part of this infrastructure, every member of the team can pull up information about individual countries and credits and includes a plethora of information. For example, individual corporate names and see the history of spreads, ratings, research recommendations, and how bonds trade relative to the credit default swap. All market information on a particular corporate issuer or corporate bond is available, giving visibility into TRACE trade indications from dealers to either buy or sell securities. This allows us to be much more efficient in not only selecting securities, but in sourcing investments.
Portfolio managers can slice and dice investments along different risk measures, and look at them on an absolute basis as well as relative to various benchmarks. This is critical given the increased complexity in the market and its volatility.
The models we built generate security- and sector-level returns across a large portion of the corporate credit markets, and cover investment grade, high yield, U.S. and global credits or government bonds. We have full transparency into the factors driving expected returns—whether valuation, momentum, or certain underlying fundamental variables a model uses, like leverage.
Fundamental researchers analyze from a bottom-up or sector-by-sector basis, and often will use quantitative outputs as a screening tool. This helps focus their time on the securities we most want to own and those the models indicate should be avoided.
As the portfolio management team evaluates these research reviews, one of its major roles is to think about risk: what is the appropriate level for the portfolio, and should it be taken up or down?
Once we answer these questions, we decide how to allocate it across four major decisions—country yield curve, sector, security, and currency—and think about how different risk allocations will interact. For example, if the fund is overweight spread risk and long the yen in currency allocation, we would currently expect these positions to be negatively correlated and help dampen overall portfolio volatility.
From research reviews and our economic forecast, we develop broad themes. One example from the past few years was that corporate credit was further along its investment cycle than consumer-oriented credit. Corporations had already finished de-levering their businesses after the financial crisis and had started to show signs of being more shareholder friendly through share buybacks and mergers, and these were increasing risk in that sector.
In contrast, consumer asset-backed securities (ABS) and commercial mortgage-backed securities were earlier in their credit cycle; specifically, U.S. consumers were still coming out of the financial crisis. They were benefiting from decreasing unemployment, so delinquencies on credit cards and auto loans were at low levels.
The strong fundamental support in these sectors led to a shift in the portfolio: we lowered exposure to corporate credit and increased exposure to consumer ABS. The fund has in excess of 10% exposure to consumer ABS, even though its stated benchmark, the Barclays Aggregate Bond Index, has only one or two percent. We chose to allocate more risk because of where sectors were in their individual credit cycles, something borne out through our research.
Q: What is your portfolio construction process?
Major drivers of portfolio construction include research reviews and high-level budgeting decisions done with quantitative tools that allow scenario analysis and stress testing. These key tools allow us to more effectively consider the correlation between the different strategies that we have implemented in the fund.
We look at top-down parameters like duration and curve positioning, currency exposures, sector allocations and what corporate sectors should be overweight or underweight. Then sector-specialty teams in credit, securitized assets, and emerging markets, help populate the fund with the best security selection ideas.
The fund’s benchmark does a reasonably good job of describing the long-term, risk-return tradeoff we are trying to achieve, but the portfolio varies from it significantly. Technically, it is an all investment-grade, U.S.-focused benchmark, and our opportunity set is definitely broader. Also, our overall risk positioning may differ dramatically depending on our research. Besides the benchmark, we consider the portfolio from absolute return and risk perspectives.
The portfolio has about 400 positions and cannot exceed 25% in below investment grade. Our general approach is diversified at an issuer or security level, especially when it comes to corporate or emerging market credits. We feel better returns can be generated without focusing a tremendous amount of the risk budget on idiosyncratic positions.
Its asset classes are also very diverse. The fund includes a full range of securitized assets, currency instruments, derivatives, and governments and corporates in both developed and developing markets. We try not to be constrained by benchmark weights, which are heavily tilted towards corporate credit and agency mortgages; we use a broader multi-sector approach instead.
The largest spread sector allocations will be a blend of corporates and the securitized sectors. Currently, the portfolio has much less exposure to emerging markets than is typical.
Q: How do you define and manage risk?
Because no one risk measure is perfect, it is important to evaluate the fund from many different perspectives. This was brought into focus during the financial crisis, when focusing on a single risk measure meant perhaps missing things. For example, centering only on tracking error versus a benchmark would miss the fact that correlations could change or that absolutely volatility is also important.
We consider absolute volatility measures as well as tracking error—but both these rely on many assumptions, especially assumptions about the correlations between markets which can be unstable. So we use scenario analysis and stress testing, which allow us to examine the implications of such assumptions on the portfolio’s returns, and determine whether we are comfortable with that level of risk.
In addition to the full range of risk controls in our investment process, we are also embedded within our firm’s culture of risk management. While the portfolio managers (myself included) are ultimately responsible for the portfolios they manage, AB maintains a number of independent risk management areas focusing on things like credit and counterparty, investment risk, and operational risk. There are also a number of risk oversight committees comprised of senior members of AB.
